4 Signs We Could Be in a Stock Market Bubble

Is the current stock market another bubble that's about to burst? Here are 4 major signs a market correction could be coming.

March 6, 2009, was a terrible day for stock market investors. The Dow Jones Industrial Average (DJIA) closed at 6,626.94, and the S&P 500 closed at 683.38. Both indices showed losses of nearly 60 percent from their peak value only six months prior. With the financial crisis in full swing, there were many financial experts who thought we were about to enter a new Great Depression with people better off saving gold bars under their mattresses instead of investing in the markets. How wrong they were!

In the five years that have passed since that fateful day in March, the markets have defied gravity with a sustained rally to record highs. The S&P 500 is up over 170 percent, and the DJIA is up nearly 150 percent. Much of these gains have been earned in the past 12 months. These are returns that usually only savvy investors can hope for, yet almost anyone willing to risk some money in the basic indices without any further analysis or effort was able to achieve gains.

Unfortunately, there are millions of investors, including many small-business owners, who didn’t have the luxury of investing in the market during this period. They were too busy putting their money to work saving their homes or their businesses—or both. But now, having overcome much of the financial and housing crises' immediate effects, they're looking again at the stock market and wondering if it’s the right time to start investing.

Timing the Market

While it’s impossible to predict what the stock market will do in the future, a number of technical indicators are cause for concern. Much of the current data points to the fact that we're likely in a bubble that could burst at any moment.

But you don’t need to be an expert in technical analysis to spot other signs that we may be in a bubble. That's because stock market bubbles don’t happen, well, in a bubble; instead, they're indicative of what’s happening in the economy overall. As business owners, we can probably spot these four signs in our daily dealings:

“This time it’s different.” If anything should serve as a red alert that we are in a bubble, it's hearing that phrase. And personally, I’m hearing it more and more. It’s not different. It never is! Finance and economics are inherently tied to human behavior, and people don’t change. The law of gravity applies to investments: Nothing can rise forever. Evangelists in finance, real estate, the Internet, technology, banking and even electronics all said, “This time it’s different” during their respective bubbles. They were all proven wrong.

“No credit? No problem!” A positive outcome from the financial crisis was that banks returned to their formerly more rigorous underwriting standards. Just having a pulse no longer meant you were qualified to take on an $800,000 mortgage. But that return to caution was apparently too good to be true. Banks and non-bank lenders are now quietly bringing back the sub-prime loan, offering higher interest rate products to people who don’t make enough money and/or have poor credit and, as a result, don’t qualify for a traditional mortgage.

“Profits? We don’t need no stinkin’ profits!” The value of a company should always be tied to its ability to generate cash and profits; any other metric for calculating value will sooner or later be proven false. Facebook's current market capitalization (the value of its outstanding shares) is nearly $175 billion. That valuation is equivalent to 100 years of Facebook’s current profits. Twitter is currently valued at nearly $30 billion, yet it has no profits and a rather questionable business model. Even Google, with its $400 billion market capitalization, trades at a price-to-earnings ratio of 33. People are willing to pay such high prices for these companies because they have faith that the management will somehow begin to churn out massive cash profits. But the minute this faith is shaken, the prices will come down hard.

“Why buy one when I can buy two at twice the price?” According to the New York Stock Exchange’s latest data, margin debt now stands at a record $451 billion, almost double the level from four years ago. Margin debt allows investors to use borrowed money for the purchase of securities with a goal of amplifying their returns. Prior to the implosion of both the finance bubble and the real estate bubble, there were similar run-ups in outstanding margin debt. People tend to take risks when they think they can’t lose.

Now that we know a bubble exists, we don't know when that bubble might burst. However, history has shown us that:

1. They always burst. Always.

2. When they burst, most people don’t expect it and are caught off guard.

3. Many investors ignore their own common sense and try to hold on, hoping it’s just a hiccup and the party will keep going.

4. By the time small investors realize they should sell to avoid massive losses, it’s too late, because prices have gone down and they can either eat the loss now or languish for years with poorly performing investments.